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What is a Cap Rate?

Cap rate is short for capitalization rate, and what this number tells you is the relationship between the sales price of a property and the income it generates. It basically tells you if you are buying an investment property at a good price. The term originated with commercial properties and has now trickled into residential property analysis as well.

To figure out the cap rate, the equation is:

Annual NET Income / Purchase Price = Cap Rate

Some notes about this equation, and therefore what a cap rate includes or tells you (or doesn’t tell you):

Net income. Note that you must use the net income on a property, not the gross. The net income is what you get after all expenses are taken out.

Mortgage payment. The cap rate does not include a mortgage payment. So don’t count that as one of your expenses when you are calculating your net income.

Adjusting purchase price. If you are buying a property needing rehab, your purchase price should be the total cost including the rehab. Whatever it takes to buy the property and for it be rentable, that’s the number you should use.

Your specific market. Just due to simple real estate economic variances between markets, the “going” cap rate of any market is likely to be different from that of another market.

The area within a given market. This pertains to different areas within a market. For example, more desirable areas compared to less desirable areas.

Property type. Generally, this would relate to single-family properties versus multifamily properties. Multifamily properties inherently come with more risk than single-family properties (mostly due to the tenants). Because they are typically higher risk, the cap rates are usually higher to make up for it. Because single-family properties are typically less risky, it wouldn’t make sense to buy a multifamily property that has a lower cap rate than a single-family property. (Note: this doesn’t include risk with such multifamily properties as high-end condos or anything like that — these statements refer to comparable properties in similar areas to each other.)

Property condition. It certainly wouldn’t make sense to buy a dumper that has the same cap rate as a freshly rehabbed, good condition property.

Risk factor. This includes risk associated with neighborhood, property type, and the property condition. Think of it in terms of a trade-off. Why would you buy something with greater risk that has the same cap rate as a property with lower risk? Your two biggest risks with any property will be with the property itself (think massive repair costs that break your bottom line) and the tenants who live in it (bad tenants are arguably the costliest thing to a rental property owner). One other major risk is vacancy, which is most directly affected by the neighborhood or market itself.

Economic cycles. The real estate economy of any market is not only dependent on the nationwide real estate economy, but on its own economy as well. The current place of a market in its economic cycle will have a major impact on the going cap rates at any particular time.

The point is cap rates vary with different property types in different locations, so when you are asking what a “good” cap rate is, you can only compare numbers in similar areas with similar property types.

Examples of Varying Cap Rate Situations

Here are some different scenarios of varying cap rates, and with each, I explain why the cap rates differ.

A 5% cap rate would be considered fantastic in Los Angeles, but horrible in Kansas City. Reason: Market Differences

The cap rate on a cute little house in the quiet outskirts of a big city might be 8%, while a similar cute little house in the popular, desired area in the middle of the same big city may only get you 1% (if even that!). Reason: Neighborhood Differences

A multifamily property has a cap rate of 11%, while a single-family property in the same general area has a cap rate of only 8%. Reason: Multifamily vs. Single-Family

There are two nearly identical houses, and one is priced to offer a 9% cap rate, and the other offers a 14% cap rate. One of the houses is in “good as new” condition, and one needs an excessive amount of work. Which do you think is associated with which cap rate? Reason: Property Condition

A 7% cap rate for a single-family home in a nice stable neighborhood in the good part of Dallas would be excellent, but it would be horrible for a triplex in the more urban Section 8 areas of Chicago. Reason: Risk Factors — Neighborhoods, Property Types, and Tenant Pool

The going cap rate in Atlanta in 2011 was around 14%. Today in 2016, the going cap rate is 6-7%. Reason: Difference in Placement in the Economic/Growth Cycle

See how a lot of those trade-offs work and how they come into play when looking at cap rates?

I constantly see people asking, “What cap rate should I expect on a rental property?” The reality is that question just can’t be answered very easily. You might be able to get away with having a hard minimum, say 5%, but what if a proposed property was a run-down multifamily in a slightly sketchy neighborhood? Would you still accept a 5% cap rate on that property? Well, maybe I would if there was solid evidence that the sketchy neighborhood was about to be gentrified and it was nearby a city like Los Angeles that experiences big appreciation waves. But for a run-down multifamily in a slightly sktchy neighborhood in some small Midwestern city? No way!

And thinking of this whole concept in reverse, be sure you always consider that a higher advertised cap rate doesn’t always mean it’s a better deal. Remember, advertised or projected returns are just that — projected. What really matters is whether or not the number will hold true, and a lot of that depends on the quality of the location and property.

I have to be honest, though. Despite all this talk about cap rates, I have to tell you that I only explained all of that because it’s the question that keeps getting asked.

There is actually a calculation I like better than cap rate.

Cap Rates vs. Cash-on-Cash Returns

Calculating the cash-on-cash return is what I believe is the more important calculation if you are trying to figure out whether a return is “good” or not. Ultimately, a cap rate doesn’t tell you how much return you are making on your investment — unless you pay for the property in cash, in which case the cap rate and the cash-on-cash return are the same.